Yesterday, we looked at the reasons for the Fed’s policy of quantitative easing. This morning, I wanted to review what the impact of QE/ZIRP has been. From there, we can assess what its end might mean.

Its hard to understate the impact the Fed can have on asset classes. Recall Y2K — the Alan Greenspan’s unwarranted fears of a run on banks led the Fed to make a modest (~$50B) liquidity injection on October 22, 1999 — nearing the peak of the Dot Com mania. The Nasdaq DOUBLED over the next 6 months. The FRB isn’t responsible alone for that rise, but they certainly can take credit for a healthy chunk of it.

In March 2009, the S&P was down 55%, sentiment panic levels were at extremes, Valuations were fairly reasonable. Into this environment, the Fed launched a massive liquidity program designed to reliquify the frozen credit markets and recapitalize the financial sector.

You may be noticing a pattern: The Fed throws a lot of firepower at a problem, often when sentiment is at an extreme. What starts out as an extraordinary emergency situation morphs into ordinary policy. This is consistent with many Central Bank interventions over time. Not only are the bankers susceptible to the emotions of the crowd, they seem to ignore, surprisingly, Behavioral Economics.

Central Bankers appear to be ruled more by fear than logic.

Hence, our present situation. Following the implementation of ZIRP, QE1, and now QE2, it appears the political will for further intervention is fading. Opponents of the policy are no longer lone voices. QE2 is very likely to end without a QE3 right behind it.

The first impact of the end of QE/ZIRP will be a rise in the US Dollar versus a basket of currencies. Some people have pointed out that the Yen never suffered during Japan’s multi-decade ZIRP policy. But Japan is a major exporter, and buyers of Japanese good must buy Yen to purchase Japanese goods. Perhaps their trade surplus helps explain why the Yen has not been pressured as the dollar was.

The Fed liquidity bid under the market will disappear. That does not mean markets will head straight down; to the contrary, other factors — earnings, contrary sentiment, short squeezes, mutual fund inflows — have the potential to keep markets afloat longer than most everyone expects.

While many people are looking for an equity collapse post QE, I wabt to suggest we widen our focus, and consider the action in Bonds and Commodities post-QE:

• Bonds: The Fed has already bought $400B of their $600B in Bonds. When that bid goes away — or if the Fed begins to reduce their balance sheet and unload these holdings, what will that do to bond prices? We should expect to see a gradual rise in interest rates, with the 30 year climbing over 5% and the 10 year breaking out over 4.25%.

• Gold: Having little industrial value — its worth is what someone else is willing to pay for it — Gold may be the most vulnerable of commodities to the end of QE.Consider that the current secular bull market for gold began under Greenspan’s rate cutting regime back in 2001. His inflationary 1% Fed rates started the entire super cycle of commodities.

• Agricultural Commodities: Its not just the weak dollar. AG has currently run up on poor crops due to drought/floods, burgeoning Asian demand, and some speculation as well.

• Oil: The Middle East is the wild card, and it makes it difficult to assess what price action could occur if the Dollar strengthens. One thing is certain: The easy speculative money has already been made. Things become much more challenging for Oil traders.

While I do not discount the probability of a significant market correction — I figure 25% peak to trough when this bull has run its course — once the Fed’s liquidity begins to drain, other asset classes will be juts as affected as equities — if not more.

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Part III will be published on Friday. It considers a) when the end of QE might be felt, b) different ways the cyclical equity bull market can end, and c) whether there will be a QE3 . . .

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

Dr. John Hussman’s weekly musing this week is on the effect of QE2 on asset prices. He makes a pretty compelling argument that the effect was to price all asset classes high enough that the forward return would be low enough that someone other than banks and the Fed would be willing to hold cash at zero return.

While your comments re: Japan are quite correct I think that there is more to the story. The more crucial point in my view is that ZIRP and QE were never able to eliminate the deflationary trend in the Japanese economy. (Parenthetically ZIRP and QE have not been able to support the Japanese stock or real estate markets over the long term.) The same will be true for the US, IMHO. In the absence of real fiscal stimulus (and by that I mean Fed fiscal stimulus that more than compensates for the 50 mini-Hoovers in the state houses) in addition to QE we will face a situation that in the end will be very reminiscent of Japan’s.

QE alone can effect the path (i.e., timings – obviously important to a money manager) but not the destination.

The Fed’s liquidity bid is much more explicit for bonds and is much more attenuated for commodities. Looking at Hussman also reinforces the point that ending QE will be closing the sluice gate after the flood waters have already headed downstream. Even without additional new liquidity, there is the big question of when and how this already created liquidity works its way into the economy and leads to repricing.

QE-2 to inflate assets as continuation to allow the big banks to unwind and to provide wealth effect to those still employed.

Little guys are just beginning to march back to the stock market. QE-3 will be needed to protect them from significant down side, unless Bernanke wants to have pies, eggs and shoes to be thrown at:

Everyday investors appear to be on board. Since the beginning of the year, investors have put $24.2 billion into U.S. stock mutual funds, according to the Investment Company Institute. They withdrew $96.7 billion in 2010.
“It didn’t feel right to be back in until now,” says Richard Dukas, who heads a public relations firm in New York City. “I still don’t want to put all my money in the market, but I believe we’ve come through the worst of it.”
After the 2008 financial meltdown, Dukas and his wife converted their 401(k) retirement accounts into cash. They had been burned during the bubble in technology stocks a decade ago, and Dukas says he has been “extremely skittish” ever since.
Now Dukas, 48, says 85 percent of his portfolio is back in mutual funds, although he maintains a small cushion of cash.
More job security, strengthening retirement account balances and improvement in the overall U.S. economy are some of the factors that have brought everyday investors back to the market. A snapshot of what’s happened:

Agree that interest rates will rise ultimately and possibly significantly, but I think that the stock market drop that will follow the end of QE2 will first create a demand for bonds that will lower rates. As mentioned earlier, I plan to put some cash into bond funds if they act predictably at this time. With luck, I may get 5% to 10% capital gains from it. I have no plans to make a kneejerk fund investment without a confirmation of a flight to safety first.

If there is a flight to safety, then I expect a stock rebound sometime after rates bottom and I hope to profit from it, also. Afterward, stocks and bonds will probably follow traditional economics. Rates will have nowhere to go but up due to massive US debt and should make a good place to park cash long term, providing you buy to hold. Learning how to manage staggered maturity bond holdings is on my list of things to do. With luck, I’ll have enough tucked away by then to be able to live off the interest without touching principal until I get old enough to amortize safely (I’m planning to live to 100.)

The coming US Debt Crisis will further cause rates to rise and stocks to fall. This is as clearly foreseeable as the credit boom and resulting real estate crash were. Timing is the only unknown. It will last years and will probably be much worse than the last bust. Fed monitization will not fix it either.

It’s hard for me to find bond trading data since my pension check won’t cover my own Bloomberg, but Wiki tells me that average daily bond trading is $82 billion out of a total inventory of outstanding US bond debt of $31 trillion.

Bernake buys $7 billion a day and suggests “the Fed’s strategy relies on the presumption that different financial assets are not perfect substitutes in investors’ portfolios, so that changes in the net supply of an asset available to investors affect its yield and those of broadly similar assets. Thus, our purchases of Treasury, agency debt, and agency MBS likely both reduced the yields on those securities and also pushed investors into holding other assets with similar characteristics, such as credit risk and duration.” In other words, other players in the bond market have to adjust for the $7 billion bought up.

Given the outstanding US debt of $31 trillion I find it hard to believe that QE2 is having any significant quantitative effect on anything. And at this point the phrase “correlation does not imply causation” needs to be mentioned because QE2 is credited with an astonishing array of secondary effects.

I would argue that the primary effect of QE2 is qualitative, or sentiment based. Since no one really knows or understands the impact of QE2 it’s pretty easy to speculate on it’s effect on gold, commodities and currencies.
Just find a hat and put some numbers in it. . .

PS, a few years ago, in this space, I coined the term Bernanke Put. It was ignored, except at ZH where it was ridiculed by a commenter and I was corrected that it should be called a Bernanke Call. (Ha Ha ZH dumbasses) I made sure to claim first dibs on the coinage here. I stopped posting at ZH shortly afterward.

High quality bonds may actually be helped perversely in the same way they were hurt when QEII was announced. It wasn’t and still isn’t inflation. The Fed’s purpose was to drive people of out bonds and into risk assets and it’s been effective as shown by the change in prices of each. The brokerage industry willingly obeyed, seeing a chance to get mom and pop to use all that cash that was safely collecting interest and, instead, to pay some commissions instead.

As in other markets pushed up by cheap money, (think housing stock bubbles) the lack of new money entering the commodity and equity markets will cause them to stall and correct, possibly in a rout as margin calls are made to the many using leverage. Leveraged markets will fair worse. .

Gold may get hit again as it did in 2008 as liquidity dried up and people sold gold because it was easy to sell to raise cash. Back then, the drop was 30%. If gold’s image of safety is tarnished, it could be worse.

reply:
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a) at that time, the greenspan put was considered mythology and tin foil hat thinking.

b) Yes, others have subsequently thought of it and I don’t claim to be a genius. I was probably making a point about the Bernanke put being a continuation of the GS put and was making it before others. I made a point of claiming dibs in the post, I believe.

You raise a lot of issues with this post. I’ll go with your gold forecast.

We have seen a 10 year rally in gold paralleling the dotcom bubble, the housing bubble, and QE1/2. Do you really think the Fed is going to suddenly get religion (ala Paul Volker) and stop the gusher of money? I would predict QE3 starting about the middle of June after the market begins to price in seriously lower asset prices. This would be bullish for gold.

QE2 pertains to the Fed buying longer dated treasuries. When QE2 ends, the Fed will presumably continue its Zero Interest Rate Policy, which means it will continue to buy T-bills in whatever quantity is required to keep short-term interest rates close to zero. So the Fed will continue funding a large portion of the federal deficit even after QE2 expires. It’s not as though QE2 ends and the influence of Bernanke & Co. disappears.

QE2 pertains to the Fed buying longer dated treasuries. When QE2 ends, the Fed will presumably continue its Zero Interest Rate Policy, which means it will continue to buy T-bills in whatever quantity is required to keep short-term interest rates close to zero.

reply:
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FOMC policy sets short term rates arbitrarily. No purchases are involved.

You are correct there. Only hope is the possibility we could see a revolt of the new Tea Party Reps that Boehner was trying to educate about reality, e.g. Wall Street campaign contributions. In another meltdown, it could be that these unsophisticated types will blame the guilty party, Bernanke, and back Ron Paul in threatening the Fed enough to keep him in line. Of course, it would be easier for them all to just blame Obama.

Yesterday, for a contrary opinion, I pushed UCLA macroeconomist, Roger Farmer. Today, I will push Bentley University macroeconomist, Scott Sumner. Like Farmer, Sumner believes that the Fed ought to directly intervene in asset markets by trading nominal GDP futures in manner to stabilize asset prices. He wanted QE1 and QE2 and wants QEx, where x={3,4, …} until such time as nominal GDP growth returns to its pre-2008 trajectory. He is also quite critical of the Fed’s tight monetary policy in the run up to financial crisis, as well as their decision to pay interest on the reserves that banks and other institutions have stashed at the Fed. Unfortunately, as the US has only a hard-money Tory Party and a liquidationist Monster Raving Looney Party, the Fed will not be given the statutory authority to trade nominal GDP futures.

RE: “The first impact of the end of QE/ZIRP will be a rise in the US Dollar versus a basket of currencies”

For a variety of reasons, including the U.S. Dollar’s technicals, I don’t believe that we will be experiencing any sustainable rise in the U.S. Dollar. Here is my most recent blog post on the topic, for those interested:

I think that QE II will actually be ended when planned, but it won’t be long after until QEIII is initiated. The reason is that Fed has got prices so queered up, particularly in the commodities markets, that a crushing oversupply is even now building. Don’t think for a minute that agriculture and oil prices are being driven just now by supply concerns. In commodities where demand is very stable, like agriculture and oil, higher prices beget higher prices because as prices go up, people pull future purchases forward. It appears demand has grown, so suppliers ramp up output. Prices crash when it becomes clear that way more wheat, corn, rice, oil, etc., have been supplied than is really needed. The declining prices will precipitate another decline in economic activity, which will bring on the next round of money-printing. Gold will be golden throughout, because it will be used as an inflation hedge on the ramp up in prices (i.e., now) and it will be sought for safety on the crash.

My guess, QEIII starts late second/early third quarter 2012 because that’s about when political uncertainty inherent with a presidential race will start impacting markets. In markets where prices are now more or less set by government fiat (i.e., Fed money monkeying in all of them), economic fundamentals, while not irrelevant, will always play second fiddle to political contre temps. Or in fact, political contre temps now determine economic fundamentals. Free market capitalism, i.e., the idea that the job of government is to create the infrastructure necessary for functioning markets and then leave them alone, died a whimpering death sometime in late 2008. Government now is the market.

Since Japanese people love to buy its gov’t bonds, it helps the Japanese gov’t continued the QE many times without too much impact on the yen (the Japanese gov’t don’t need to “print money” to buy its own debt). For the US treasury, it was bought by “money printed out of then air” from the FED, so money printing really hurt the value of USD.

However, it seems the new generation of Japanese are not saving as much and may not have as much loyalty to its gov’t compare to the older generations. Japanese bonds would pop eventually, and the yen will tank.

I am not sure if the US would follow the Japanese. The Japanese gov’t can sell its bonds to the Japanese people. I think 90%+ of Japanese bond holders are Japanese citizens. In the US, the bond holders are foreigners, US citizens and the FED in which the FED is gaining significant % after QE1 and QE2. The FED purchased UST with printed money, so USD can’t hold its value.

So far, the US Gov’t would not want to another obvious recession, so there is not likely significant changes that would reduce the US deficit. As the debt grows, FED would have to print more and more money as this is the only thing Bernanke knows about. Since the US gov’t doesn’t have the will to reduce debts and the FED only knows how to print money, QE3 will come eventually once the market falls enough and the recession is apparent to the common men.

His take is to expect a repeat when we saw the hiatus between QE I and II…here’s what happened then:

Last year, from April 23rd through to August 27th, the Fed allowed its balance sheet to shrink from $1.207 trillion to $1.057 trillion for a 12% contraction as QE1 drew to a close. Go back a year to the Federal Open Market Committee minutes and you will see a Federal Reserve consumed with forecasts of sustainable growth and exit strategy plans. A sizeable equity correction coupled with double-dip fears were nowhere to be found.

Now over that interval …

•S&P 500 sagged from 1,217 to 1,064.
•S&P 600 small caps fell from 394 to 330.
•The best performing equity sectors were telecom services, utilities, consumer staples, and health care. In other words — the defensives. The worst performers were financials, tech, energy, and consumer discretionary.
•Baa spreads widened +56bps from 237bps to 296bps
•CRB futures dropped from 279 to 267.
•Oil went from $84.30 a barrel to $75.20.
•The VIX index jumped from 16.6 to 24.5.
•The trade-weighted dollar index (major currencies) firmed to 76.5 from 75.5.
•Gold was the commodity that bucked the trend as it acted as a refuge at a time of intensifying economic and financial uncertainty — to $1,235 an ounce from $1,140 and even with a more stable-to-strong U.S. dollar too.
•The yield on the 10-year U.S. Treasury note plunged to 2.66% from 3.84%.

Anyone who thinks “rates will rise” when QE2 ends… needs to look at what happened when the Fed stopped buying mortgage bonds. (Super big drop in rates to all time lows).

The biggest factor here is that the MARKET pre-pares for the end of QE2. So the Fed has been buying and others havent… rates have done up a bit. Many have shorted bonds in anticipation of a weak dollar and QE2 sell-off.

BUT… those others still want treasuries. The overall facts are that there is VERY LITTLE UST supply versus worldwide real demand. This is even more true when you consider roughly half of US funding is in TBills (not bonds) and only about 1/4 of US funding is beyond the 5-yr point.

Should the govt actually shink borrowing a bit (tax reciepts bounce huge in a recovery)… then there is a big short squeeze in USTs. This is what we had last year. This is the Japan dynamic. At the EOD there is HUGE demand for riskless assets at almost any price, and very little supply.

These first 2 parts have been excellent, BR — I look forward to the 3rd installment — you need to schedule some beach R&R on a more frequent basis (just let us know so we can put some appropriate leverage in place before the fact).

However, I notice that in pretty much all of your forecasting as to the amounts that the markets will advance or decline by, you make the tacit assumption that our societal backdrop will remain unchanged — that our climate of endemic corruption and financial influence over the management of the nation will continue unchanged.

When this changes — and it will change at some point or other, as we are at historic extremes in this area, comparable to the rule of the robber barons in the 19th century, Boss Tweed and Tammany Hall, and the climate of Wall Street fraud and larceny that prevailed around the time of the Crash of ’29 — the historical bounds that (apparently) form the basis of your assessments of how far the markets will move will get blown away, and valuations will sink to single-digit multiples, and the game board will be reset.

When this occurs (admittedly, it is nowhere on the horizon, but then I suspect that like the Spanish Inquisition, these changes are never expected), it will be a New Ball Game.

For your next series of insightful and well-reasoned pieces, how about a BR look at the (related) problems of too much debt (as compared to the size of the economy), a climate of rates that are too low (which makes it possible for the economy to survive the levels of debt, but not to grow and certainly not to thrive), and the additional demographic complications that the retiring boomers bring to the (big) picture? Yesterday’s Rosenberg market letter is a good jumping off point, if a tad biased.

As soon as QE stops, all asset classes will deflate, the banks will have unlimited cash on hand to buy assets at fire sale prices (damn the debt — the money is free, pay the minimum, if anything at all), and the final crush-down to serfdom for the middle class will be complete.

Those “middle class serfs” seem to be drinking Starbucks, talking on their IPhones, watching 1,000 channels of DirectTV and jamming the airports to get to their spring break cruise. Or loading up the large SUV to which they hitch the boat.

As for QEIII, from Kindleberger, 1978, “… At such times a lender of last resort (government) can provide financial stability or attenuate instability. The dilemma is that if investors knew in advance that government support would be forthcoming, markets might break down even more frequently. […] This is a neat trick for government to perform: always come to the rescue, in order to prevent needless deflation, but always leave it uncertain whether rescue will arrive in time or at all….”.

Also, the Japan FED removed stimulus too soon, the market deflated, losing the benefit of prior stimulus. Bernanke is working this like the depression which took 25 years for asset prices to stabilize.

Whatever happened after QE1 almost ended but before QE2 started will happen again before QE3 if there is one starts.

If there is NO QE3, then what ever happened after QE1 will deepen into uncharted territory, most likely NOT good for equity markets!

Euro crisis is NOT going away. Housing values continue to decline and Banks are surviving on Enron style accounting. Nothing sigificant reform done or addressed in 2008 just postponed and covered up with TARP, TALK, HAMP and QE1+2, ZRP.

Amazing isn’t that Market recovered nearly 100% from it’s low with absolutely no real reform but printing press working overtime and perception spin with Liquidity borrowed from future. No one wants recession which has been part of business cycles, but just perpetual growth!

i have been very interested in finding out people’s opinions on what will happen to silver once QEII is over.

silver has many more industrial applications than gold, so if the economoy recovers, silver should do well. however, if the economoy goes into a tailspin after QEII is over, silver could still do well as a flight to safety. also, if the dollar strengthens silver/gold should technically go down. i am torn over whether or not I should sell my silver (2 x 100 oz bars, both bought below $20/oz) now or hold on in hopes prices go up.

my gut feeling is that there will be an opportunity(ies??) to buy silver again below $25/oz, and gold below $1100, possibly even lower than $1000. so i’d like to sell now and lock in profits and buy back again at a cheaper price. but prices could keep going up, who knows, maybe to over $40/oz. any thoughts??

You are not looking at wealth, you are looking at debt — there’s a good chance that the coffee and/or iphone went on a credit card. The vacation and the boat, most certainly. The middle class is engorged with debt, and prospects for increased income are bleak, at best. The rank and file are not entrepreneurs (and even if they have the bent, most have no capital on which to build), and going concerns will have no need for a bloated middle management class, going forward. We, in aggregate, are broke (thus, the need for a conversation about QE).

Pimco zeroes out Treasury holdings. Bond giant Pimco confirmed it has unloaded all of its U.S. government holdings, including Treasurys, in the Total Return Fund. The $237B fund previously had 12% of its assets in U.S. government holdings, and had as much as 63% of its assets in U.S. government-related debt in late 2009. Bill Gross, the fund’s manager, is trying to get out ahead of the end of QE2, when he expects a rise in bond yields, and a concurrent fall in bond prices, would drive down the value of the bonds

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About Barry Ritholtz

Ritholtz has been observing capital markets with a critical eye for 20 years. With a background in math & sciences and a law school degree, he is not your typical Wall St. persona. He left Law for Finance, working as a trader, researcher and strategist before graduating to asset managementRead More...

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